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Making Sense of the Dow's 425-Point "Plunge"

The nearly 122-year-old index's flaws were on full display on Tuesday.

As has become all-too-common since the beginning of February, the nearly 122-year-old Dow Jones Industrial Average(DJINDICES:^DJI) tumbled once again on Tuesday, April 24. When the closing bell rang, the Dow had shed approximately 425 points, paring some of its intraday loss, which briefly crossed a decline of 600 points around 2 p.m. ET.

Why did the Dow "plunge" once again? If you read the headlines from various news outlets, the blame was predominantly placed on industrial giant 3M, which cut its full-year outlook, and heavy-duty machine manufacturer Caterpillar, which sold off after reporting better-than-expected quarterly operating results.

Additionally, investors fretted over 10-year bond yields hitting 3% for the first time since 2014. As Treasury yields rise, the belief is that some investors could choose to swap out of riskier and more volatile stocks and jump into bonds, which offer a more guaranteed return. Historically, a rising interest rate environment isn't great news for stocks or the U.S. economy.

Image source: Getty Images.

The Dow's inherent flaws are exposed in Tuesday's 425-point decline

But if you want the truth behind why the Dow "plunged," look no further than the index's archaic and flawed way of accounting for "points."

You see, the Dow Jones Industrial Average is a point-based index. Rather than factoring in the market caps of its 30 underlying components -- as the broader-based S&P 500(SNPINDEX:^GSPC) does for its more than 500 components -- its daily moves up and down are determined by the aggregate point increases and decreases of these 30 stocks, with a Dow divisor used to calculate the actual move in Dow points. This divisor is constantly updated to reflect splits, dividends, spinoffs, and the removal and addition of new companies into and out of the Dow Jones Industrial Average.

Currently, the Dow divisor sits at 0.14523396877348, according to The Wall Street Journal. This means that every full $1 move higher or lower in a Dow component translates into approximately 6.89 Dow points. In other words, Dow stocks with a higher share price have far more weighting than those with a lower share price, regardless of market cap.

On Tuesday, April 24, 3M and Caterpillar lost a respective $14.75 and $9.55 per share. This combined for 167.31 points of the Dow's 425-point decline. If we also add Boeing and Goldman Sachs, which have the two respective highest share prices in the Dow, these four stocks accounted for 263.44 points of the Dow's Tuesday decline.

And if you think that's a headscratcher, you haven't seen anything yet.

Image source: Getty Images.

This approach is all wrong

The highest share price stocks in the Dow at the moment are:

Boeing: $329.06

Goldman Sachs: $242.49

UnitedHealth Group: $234.22

3M: $201.13

Home Depot: $176.26

If we add the share price of these five components up and use the divisor, we learn that they're responsible for an aggregate of 8,147 Dow points, or just over a third of its current point value. Now, let's compare this to the Dow's five lowest share price stocks:

General Electric: $14.68

Pfizer: $37.06

Coca-Cola: $43.07

Cisco Systems: $43.74

Verizon: $49.67

Combined, these five Dow components only account for 1,296 Dow points. This means the five companies with the highest share price have over six times the influence of the five components with the lowest share price.

Yet, here's the real kicker: the aggregate market cap of the lowest share price Dow stocks is $954.5 billion compared to $842.2 billion for the largest five.

Just as interesting, Apple, the sixth-highest-priced Dow stock, nearly has an identical market cap ($826.8 billion) by itself relative to the five highest-share-price components, yet is only responsible for 1,122 Dow points. That makes little sense.

Image source: Getty Images.

What you should do

So, why does Wall Street still pay so much attention to the Dow if it's such a flawed index? Much of it has to do with the history behind the Dow. Next month it'll turn 122 years old. Aside from the Dow Jones Transportation Index, it's the oldest stock index around. The Dow is also comprised of multinational companies that matter, so it still gets its fair share of looks.

But for the retail investor, the Dow should be treated as nothing more than a novelty. It lacks the sector- and industry-based diversification that the S&P 500 offers, suggesting that it no longer accurately represents the health of the U.S. economy. It also excludes major players -- Google parent Alphabet and Amazon -- because their $1,000+ share price would dominate the point-based index.

While it might be fun to give the Dow its kudos from time to time, you're much better off making the S&P 500 your primary measure of stock market health.

Author

A Fool since 2010, and a graduate from UC San Diego with a B.A. in Economics, Sean specializes in the healthcare sector and investment planning. You'll often find him writing about Obamacare, marijuana, drug and device development, Social Security, taxes, retirement issues and general macroeconomic topics of interest. Follow @TMFUltraLong